Research Paper. Financial Statement Policy Liability Sensitivity Disclosure for Life and Health Insurers

Transcription

1 Research Paper Financial Statement Policy Liability Sensitivity Disclosure for Life and Health Insurers Working Group on Financial Statement Disclosure Committee on the Appointed/Valuation Actuary December 2009 Document Ce document est disponible en français 2009 Canadian Institute of Actuaries Research papers do not necessarily represent the views of the Canadian Institute of Actuaries. Members should be familiar with research papers. Research papers do not constitute Standards of Practice and therefore are not binding. Research papers may or may not be in compliance with Standards of Practice. Responsibility for the manner of application of Standards of Practice in specific circumstances remains that of the members in the life insurance practice area.

2 Memorandum To: From: All Life Insurance Practitioners Tyrone G. Faulds, Chairperson Practice Council Ralph Ovsec, Chairperson Working Group on Financial Statement Disclosure Date: December 14, 2009 Subject: Research Paper: Financial Statement Policy Liability Sensitivity Disclosure for Life and Health Insurers The Committee on the Appointed/Valuation Actuary has developed the attached research paper, Financial Statement Policy Liability Sensitivity Disclosure for Life and Health Insurers. This research paper is being released in its final form. The research paper is intended to aid Appointed Actuaries in developing policy liability sensitivities for disclosure purposes in the financial statement notes and other supplementary financial statement disclosure. Currently, no guidance exists on how policy liability sensitivities to be disclosed are constructed. A wide variety of practices have developed between companies to determine how sensitivity disclosures are developed. These include the assumptions for which sensitivities are shown, the level of assumption changes tested, and the construction of the assumption tests themselves even when similar sensitivities are theoretically being tested. These differences between company disclosures pose reputation risks for the actuarial profession, since external users, particularly those who follow the public reporting life insurers, do commonly compare results between companies and would expect reasonably consistent practices to be followed. While we recognize that disclosure practices in this area are ultimately the responsibility of company management, we believe that a research paper with a common base framework of good practice for how such sensitivities can be constructed will help bring more consistency in practice. To that end, the working group that developed this research paper had members from all the largest public reporting companies. In accordance with the Institute s Policy on Due Process for the Adoption of Guidance Material Other than Standards of Practice, this research paper has been approved by the Committee on the Appointed/Valuation Actuary, and has received approval for distribution from the Practice Council on November 3, The committee would like to thank the members of working group: Ralph Ovsec (Chair), Jim Doherty, B. Dale Mathews, Brian Phelps, Geoff Strowger, and Frédéric Tremblay. TGF, RO

3 Overview This working group was formed by the Committee on the Appointed/Valuation Actuary. The objective of the group was to identify the sensitivity of policy liabilities to changes in assumptions and market movements in the published financial statements of the large public Canadian life and health insurance companies and propose a common set of sensitivity disclosures in order that external users of financial statements can more readily compare published financial statements. The working group consisted of the following members: Discussion Jim Doherty (Ernst and Young) Dale Mathews (Manulife Financial) Ralph Ovsec (Manulife Financial) Brian Phelps (London Life) Geoff Strowger (Sun Life Financial) Frédéric Tremblay (Industrial Alliance) There is increasing pressure for more and more disclosure in companies published notes to financial statements and Management s Discussion and Analysis (MD&A). Notwithstanding that certain disclosures are already an existing requirement, from a public policy perspective it is desirable to report sensitivities of policy liabilities in a consistent manner. A review of the 2007 annual statements showed that sensitivities based on different levels of change in the valuation assumptions were being disclosed. This can be an issue as the sensitivities are often not linear and therefore not easily comparable. Of greater concern, however, was that there was lack of uniformity in the application and determination of the sensitivities. This working group has proposed disclosure that is more uniform numerically across companies and has addressed some of the inconsistencies of measurement. Mortality is a good example of both points. Not only are there differences in the level of adverse experience that is tested, but also in how the adversity is calculated. In the case of mortality sensitivity, some companies report adversity on insurance and annuities separately, while others calculate the sensitivity unidirectionally only. The approach generally is a compromise between the Canadian Institute of Chartered Accounts (CICA) guidance for asset risk disclosure where it is suggested/recommended that the sensitivity quantified be related to the likely change that could occur in the course of a year and a sensitivity that can be easily extrapolated within small ranges (although it should be recognized and the user be aware that the relationships are usually not linear). The most comparable, and therefore relevant, measure of sensitivity is the impact on shareholder surplus. Consequently the most appropriately defined measure is after-tax impact of the change in policy liabilities (net of the change in asset values where appropriate), after the impact of income taxes and after consideration of income tax timing differences. Any pass-through features would be considered when reporting the sensitivities. 2

4 The working group addressed the following assumptions and market movements for policy liability sensitivity disclosures: Mortality/Morbidity, Expense, Policyholder Behaviour, Movement in Financial Markets. The working group proposes the following valuation sensitivity testing. ELEMENT SENSITIVITY ADDITIONAL COMMENTS A. Insurance Mortality 2% adverse change Insurance and annuity to be shown separately; insurance would be unidirectional (i.e., no separate treatment of death-supported products) Morbidity 5% adverse change to best estimate disability income termination rates for disabled lives; 5% adverse change to best estimate incidence rates for all morbidity risks for active lives Combine active and disabled lives B. Expense 5% increase in best estimate maintenance expense assumptions All administration expenses that would require a Margin for Adverse Deviations (MfAD) C. Policyholder Behaviour D. Investment Interest 10% change to best estimate policy termination rates 100 basis points immediate parallel drop and parallel increase at all points on the yield curve 10% applied to obtain adverse impact Immediate impact of change in current market rates on the valuation, assuming no other component of the reinvestment scenarios used by the company to 3

5 100 basis points immediate parallel drop and parallel increase at all points on the yield curve, with change persisting for one year determine policy liabilities is changed Reflects impact of the change on all aspects of the reinvestment scenarios used by the company to determine policy liabilities (including but not limited to impact on prescribed ranges) Equities/Real Estate 10% increase and decrease for equities and real estate 100 basis points increase and decrease in future returns Each of the above elements is discussed in detail below. Rationale is given for the selection of the sensitivity measure, and it would be appropriate to include some version of the wording when reporting the sensitivities to give the analysts more insight into the business and the nature of the sensitivities. A. INSURANCE RISK Sensitivity and Quantification Mortality +/- 2% in all years, whichever is adverse Morbidity 5% adverse experience in all years Description of the Risk and the Nature of the Risk Mortality For insurance products, the risk is normally that mortality experience may prove to be higher than currently assumed in the valuation causing liabilities to increase. Conversely, the assumption of higher projected mortality experience for products such as Long-Term Care (LTC) and payout annuities might cause liabilities to decrease. Sensitivities would be disclosed separately for those products where an increase in mortality results in higher liabilities and those products where a reduction in mortality results in higher liabilities. For example, it would be appropriate in most instances to separately aggregate insurance and annuities. The quantification would be made on liabilities net of reinsurance. Where a company is reflecting mortality improvement in the valuation of insurance products, the 2% would represent a net annual impact, i.e., inclusive of any change in additional provisions for adverse deviations (PfADs) set up related to mortality improvement. Morbidity This risk would apply to liabilities whose term is greater than zero (e.g., LTC, Long-Term Disability claims reserves). 4

6 For LTC and Disability Income Active Life reserves, the sensitivity would be to incidence rates and adverse experience would be represented by higher rates, with no change to termination rates. For disability claims reserves, the sensitivity would be to termination rates and adverse experience would be represented by lower termination rates. There are a number of types of products where a reserve-sensitivity would not apply as the term of the liability is zero, yet there is morbidity risk. It would be appropriate to disclose which types of products have been excluded from the sensitivity for this reason. B. EXPENSE RISK Sensitivity and Quantification 5% increase in maintenance expenses Description of the Risk and the Nature of the Risk In the past century, expense levels have moved significantly. Contributing factors have been productivity improvements, technology, mergers and acquisition (M&A) activity, inflation, and other internal and external influences. The risk we are trying to measure is that operating expenses increase unexpectedly and indefinitely in excess of the inflation assumption, leading to an increase in actuarial liabilities and a decrease in income. The assumptions to be tested are the best estimate unit expense assumptions used in valuation. The expenses to be included in the sensitivity testing would be consistent with the CIA educational note, Best Estimate Assumptions for Expenses (developed by the Committee on Life Insurance Financial Reporting (CLIFR) and published in November 2006), which documents expenses to be included in the valuation. The sensitivity testing includes: Administration-related expenses, Benefit-related expenses, A portion of corporate and overhead expenses appropriately associated with the preceding expenses. The sensitivity testing excludes: Income taxes, Investment-related expenses, Expenses not subject to a margin for adverse deviations, such as: investment income tax, contractual commissions, and premium tax. The inflation assumption used in valuation continues to be used unchanged in the sensitivity testing. 5

7 C. POLICYHOLDER BEHAVIOUR RISK Sensitivity and Quantification +/- 10% (multiplicative) as directionally applied in the valuation Description of the Risk and the Nature of the Risk It is common practice to illustrate this sensitivity based on sensitivity to policy termination rates, notwithstanding that policyholder behaviour has several aspects. In general, policy termination rates are relatively stable on life insurance policies unless there is a significant increase in interest rates that, for example, causes a wholesale switch from average money products to new money products as occurred in the early 1980s. In some types of annuity business though, where policyholders may opt to withdraw their funds on a guaranteed basis, the rates can be very volatile and dependent upon market interest rates or the levels of equity markets. In these cases it is common for policy termination rates to be set dynamically to reflect the interest assumptions that may be applied in the valuation process, which can be either deterministic or stochastic. For lapse-supported products, the policy termination assumptions tend to be very low and, with the growing availability of viatical arrangements, are likely to remain low. The risk is that policy terminations will be higher than expected when the payment to the policyholder is greater than the reserve release, and conversely lower than expected when the payment to the policyholder is smaller than the reserve release. D. INVESTMENT RISK Sensitivity and Quantification ± 100 bps 1 immediate parallel change in the yield curve, ± 100 bps 1 immediate parallel change in the yield curve, where the change persists for one year, ± 10% change in equity and real estate, ± 100 bps on future equity and real estate return. Each of these would be disclosed separately. Description of the Risk and the Nature of the Risk Due to the long-term duration of some life insurance products, which exceeds that available on many current investment options, reinvestment interest rates are a major risk. For the same reason, a portion of the assets is often invested in non-fixed income products that normally give an expected higher return but with higher risk and volatility. For annuity products, the shorter duration of liabilities allows a better match than for life insurance, but imperfect matching and the use of non-fixed income products may also threaten future profitability. Fixed income refers mainly to bonds and mortgages. A test related to reinvestment risk is very useful in assessing the asset-liability matching of the insurer. 1 When the starting yield curve has values below 1%, any yields that would become negative when reduced by 100 bps would be floored at zero. 6

8 Non-fixed income refers mainly to equity (including units/exchange Traded Funds (ETFs)) and real estate. It is important to test all non-fixed income. Even though real estate may not be as volatile as equity, many factors may impair future return such as a reduction in renters, defaults on lease payments or a change in markets requiring a lowering of rents. Non-fixed income may be impacted by a sudden change in value as well as a future return different than expected. Therefore, testing the two separately will allow users to assess the impact of both events since a drop in equity value may not necessarily lead to an expected lower return. The quantification would be a net amount, include both the impact on the value of liabilities and on the value of assets supporting these liabilities. Disclosure of the impact of an immediate 100 bps change at all points on the yield curve. The purpose of this disclosure is to understand the immediate impact of a change in market interest rates, assuming no other component of the reinvestment scenarios used by the company to determine policy liabilities is changed. 2 Practically, this can be interpreted as a 100 bps change in the risk-free rates, with no change to spreads. If it is not practical to re-perform the entire Canadian Asset Liability Method (CALM) testing as of the valuation date, it is suggested that an approximation method, consistent with the approach used for calculating the reported policy liabilities, be used. Disclosure of the impact of an immediate 100 bps change at all points on the yield curve, while including the effect of this change persisting for one year. This would essentially reflect the impact of the change on all the aspects of the reinvestment scenarios used by the company to determine policy liabilities. This includes, but is not restricted to the impact on prescribed ranges and how these impact the reinvestment scenarios used by the company. Again, for practical reasons, the change may be quantified using approximations consistent with the approach used for calculating the reported policy liability. To aid users, companies would discuss the reason(s) for this additional impact. The indicated disclosure of a 10% change in the market value for equities and real estate, and of a 100 bps change in future returns on these assets is intended to add appropriate levels of sensitivity to the exposure to non-fixed income assets similar to that indicated for fixed income assets. For good disclosure practice, companies would comment on the conditions and/or factors that would cause future equity and real estate return assumptions to be changed. Because sensitivity is calculated as the net after-tax change in both assets and actuarial liabilities valuation, future Management Expense Ratio (MER) losses are captured for segregated funds and universal life to the extent they are included in the liabilities. Therefore, products with no liabilities such as mutual funds are not included in the sensitivities. 2 For example, for the purpose of this disclosure it is reasonable to assume no change in the risk-free rate after the 40 th anniversary used in the Base Scenario (as described in paragraph of the Standards of Practice) or any changes in the prescribed ranges of short-term or long-term Canadian risk-free interest rates for the ultimate forecast period as described in paragraphs and.2 (which would in any case be negligible). 7

9 APPENDIX A This appendix summarizes how the level of sensitivity that is being reported on was determined. This wording can also be used as guidance for external disclosures to add further insight into the effect of permanent changes to selected assumptions. It is acknowledged that there are still some company-specific considerations in this area. A good theoretical framework for developing consistent levels of adverse movement across assumptions remains to be done. A. INSURANCE RISK The level of 2% chosen for mortality seemed to represent a plausible change in the base mortality assumption over one year. It is close to the proposed level of mortality improvement being considered by CLIFR (1% - 2% per annum based on recent long-term studies). A significantly higher level of deterioration, say 10%, over the long term is more catastrophic in nature. It would also be likely to have secondary effects, such as recapture of reinsurance where possible, which would be difficult to capture consistently among companies. The 2% change in the mortality assumption would be applied in a multiplicative manner. For morbidity, the 5% represents the low end of the range of margin for adverse deviations (5% to 20%) in the Standards of Practice. This range as a percentage of the underlying assumption is higher than that for insurance mortality where the range is 3.75/ex to 15.00/ex. B. EXPENSE RISK Since 1923, the annual change in the Consumer Price Index (CPI) in Canada has varied from less than zero to almost 15%. The average annual change since 1923 is between 3% and 3.25%. Using a 5% increase for testing expense sensitivity is a balance between the average annual change and the maximum annual change in the CPI since C. POLICYHOLDER BEHAVIOUR (Lapse) RISK It was concluded that all types of business would be covered in this disclosure and that the user would not be well served by a formula that was unduly complex. Therefore, it is recommended that a simple sensitivity to a 10% change in the assumed rates be disclosed and that it be multiplicative and directional as applied in the valuation. Note that the contribution of the lapsesupported business to the aggregate is likely to be very small. In view of the practical issues involved in separating the impacts from fewer terminations from those with more terminations, the disclosure would be of an aggregate adverse impact. D. INVESTMENT RISK Guidance on the level of sensitivity to be quantified is contained in CICA 3862; however, in paragraph 3A it is indicated that the guidance given in CICA 3861 may be employed. This leads to a 100 bps change in the interest environment, which is consistent with the practice of the major chartered banks. Since 1924, the equity return (S&P/TSX) over one year has been lower than 10% in 14% of the analysed periods. Real estate markets are less volatile. Since 1973, annual returns on real estate have been very good. Those returns were negative in two years only and higher than 20% in three years over the period (source : Mortguard Investment Limited for , 8

10 Russell Canadian Property Index for , ICRED/IPD for 2000+). Accordingly, a 10% change in equity and real estate values is an appropriate sensitivity test. A change of 100 bps in the assumed future rate of return on equity investments is considered consistent, given that the expected return is comprised of the risk-free return plus a premium for the equity risk. 9